Friday, May 6, 2016

Recent comments from the
President of the Boston Federal Reserve Bank have gone pretty much unreported
by the mainstream media, however, they give us a glimpse into what could be an
unanticipated change in the Fed's monetary policies. While everyone has
grown accustomed to the dovish tone of Ms. Yellen's interest rate
pronouncements, at least one of her Fed colleagues is looking increasingly
hawkish, an issue that should be of concern to both equity and bond investors.

A recent speech entitled "Are Financial Markets Too Pessimistic About the Economy" given
by Boston Fed President Eric Rosengren at Central Connecticut State University
he points out the strengths in the U.S. economy including dropping
unemployment, rising labor force participation and inflation that is closer to
the Fed's two percent target. Despite the turbulence in the global
market, he notes that the U.S. economy and stock market have remained
resilient. He also observes that the current prices in financial markets,
particularly the Treasury market, reflect the expectation that there will be
very few interest rate increases than have been historically normal when the
Fed begins to raise rates after a recession with Fed Fund futures reflecting
the expectation that interest rates will rise only one-quarter of a percentage
point in each of the next three years for a total of three-quarters of a
percent by the end of 2018. Here is a graphic from his presentation
showing the anticipated Federal Funds interest rate path in the current recovery as well as
the interest rate paths for the post-recession period from the previous two
recessions:

As you can see, investors
are anticipating that the slope of tightening in this later years of this economic expansion will be far lower
than either the period between 1994 - 1995 and 2004 - 2006.

Here is a graphic showing what has happened to
the yield on ten-year Treasuries since the beginning of 2014:

This strongly suggests
that investors have largely been ignoring any future interest rate increases
and are behaving as though the Fed Funds rate will remain at historical lows.

Now, let's look at what
Eric Rosengren had to say about the future trajectory of interest rates in his
speech:

"While I believe
that gradual federal funds rate increases are absolutely appropriate, I do not
see that the risks are so elevated, nor the outlook so pessimistic, as to
justify the exceptionally shallow interest rate path currently reflected in
financial futures markets. The forecast for economic variables contained in the
most recent Fed policymakers’ Summary of Economic Projections is consistent
with my own estimate – GDP growth slightly above potential and a continued slow
decline in the unemployment rate.

Furthermore, I would
point out that the extremely shallow rate path reflected in the market for
federal funds futures seems at odds with forecasts by private sector economists
and by financial firms that serve as counterparties to the Federal Reserve (the
so-called primary dealers), as well as my own forecast for the U.S. economy.
Most of these forecasts envision a much healthier U.S. economy than is implied
by that unusually shallow path of the funds rate, and many of the major private
forecasters expect short-term rates to rise more rapidly than implied by financial
futures."

One of the key issues
that Mr. Rosengren expects will put upward pressure on interest rates is
employment. He anticipates that the unemployment rate, currently sitting
at 5 percent, will continue to drift downward. His interpretation is that
the unemployment rate is already close to his estimate of full employment which
is at the 4.7 percent level, particularly with the economy creating roughly
200,000 jobs monthly as shown on this graph:

If the economy were to
continue to create jobs at the current rate, the unemployment rate could fall
well below the natural rate of unemployment, the lowest rate of unemployment
that the economy can sustain over the long run without raising the spectre of inflation. Here is a graph showing
the Blue Chip forecast for the unemployment rate out to the end of 2017 showing
that most experts anticipate that the economy could overshoot the full
employment target:

The only way that
unemployment can fall below its natural rate is if inflation rises, as shown on
the Phillips Curve for the years between 1961
and 1969:

If falling unemployment
led to inflation that was higher than the Fed's 2 percent goal, the Fed would
be forced to act rapidly, abandoning its current dovish sentiments by increasing interest rates.

If we look at the latest dot plot from the Federal Reserve, we
can see that by 2018, half of the FOMC members feel that the appropriate
Federal Funds rate would be in excess of 3 percent, more than 2.5 percentage
points above the current level of 0.5 percent:

This is far above the 0.75
percentage point increase that the financial markets are anticipating.

As we can see from this speech by Boston Federal Reserve Bank President Eric Rosengren, the "new normal" of low interest rates is something that cannot be counted on. It also shows us that the braintrust at the Federal Reserve is just as uncertain about the future direction of the economy as the rest of us. That said, investors should be aware that the Fed could abandon its current monetary policy at any point in the future, a move that would put significant downward pressure on overheated equity and bond valuations.

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About Me

I have been an avid follower of the world's political and economic scene since the great gold rush of 1979 - 1980 when it seemed that the world's economic system was on the verge of collapse. I am most concerned about the mounting level of government debt and the lack of political will to solve the problem. Actions need to be taken sooner rather than later when demographic issues will make solutions far more difficult. As a geoscientist, I am also concerned about the world's energy future; as we reach peak cheap oil, we need to find viable long-term solutions to what will ultimately become a supply-demand imbalance.